Principles of Investment Risk - 1

Question 1

Simple Compound Interest Formula?

Answer 1

FV = PV ( 1 + r )^n

Question 2

Discrete Interval Compound Interest Formula?

Answer 2

FV = PV ( 1 + r/ j)^nj (where j = frequency

Question 3

Continuous Compound Interest Formula?

Answer 3

FV = PV * e^RT

Question 4

Present Value Formula?

Answer 4

PV = FV / ( 1 + r )^n

Question 5

PV of an annuity?

Answer 5

PV of an annuit y = P × (1- (1 + r ) -n /r)

Question 6

PV of an Perpetuity?

Answer 6

PV of a perpetuity = Amount of periodic payment / r

Question 7

Perpetual Bond Calculation?

Answer 7

Price = annual coupon rate / gross redemption yield

Question 8

Preference share Calculation?

Answer 8

Price = Dividend / Holder’s expected return

Question 9

What is the formula for the future value of frequent idientical payments (if payment at start of year)?

Answer 9

Question 10

Compound Interest to Regular Payments Calculation (if payment at end of year)?

Answer 10

Question 11

Basic Inflation Calculation?

Answer 11

Nominal return − Rate of inflation = Real return

Question 12

Accurate Inflation Calculation?

Answer 12

(1 + Real rate of return ) × ( 1 + Inflation rate ) = 1 + Nominal rate of return

Question 13

What is the difference between Systemic risk & Systematic risk

Answer 13

• Systemic Risk = financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries
• Systematic risk is one which affects the financial system as a whole e.g. inflation or interest rates

Question 14

What is Unsystematic Risk?

Answer 14

Those which relate to a particular business, investment or share so they can usually be reduced through diversification

Question 15

What is the relationship between variance and standard deviation?

Answer 15

Standard deviation is a square root of the variance of the dispersion

Question 16

What is the coefficient of variation and its uses?

Answer 16

• Coefficient of variation ( CV ) = σ (sd) / µ (mean)
• The CV is a measure of the amount of risk taken with each investment for a 1% unit of return, thus allowing us to make comparisons between two investments

Question 17

What level of correlatiom maximises diversification?

Answer 17

• Diversification benefit is maximised by holding investments exhibiting low (ie, close to zero) correlation

Question 18

Holding Period Return (HPR) formula?

Answer 18

HPR = (Sum of all income + Ending Valuation - Starting Valuation) / Starting Valuation

Question 19

Money Weighted Rate of Return (MWRR) formula?

Answer 19

MWRR = (Sum of all income + Ending Valuation - Starting Valuation +/- New money during the year) / Starting Valuation + ∑ (new money * n/12)

Also known as IRR

Question 20

Time Weighted Rate of Return (TWRR) formula?

Answer 20

TWRR = (1 + R1)(1 + R2)…..(1 + RN) − 1

Where R i is the simple return in each sub-period, calculated as:

Ri = (V1 − V0) / V0

Question 21

Sharpe Ratio formula?

Answer 21

Sharpe ratio = (Portfolio Return - Risk Free Return) / σ

Question 22

What is the Sortino Ratio and its formula?

Answer 22

Same as sharpe ratio but only measures downside risk

Sortino ratio = (Portfolio Return - Required rate of Return) / σ of returns below threshold

ANY RATE OF RETURN BELOW THE REQUIRED RATE IS INCLUDED IN THE CALCULATION

Question 23

What is the Treynor Ratio and what does it measure?

Answer 23

Treynor ratio = (Portfolio Return - Required rate of Return) / β Beta

the higher the ratio, the greater the excess return that is being generated by the portfolio for each unit of overall market risk

Question 24

What is the Jensen’s Alpha and what does it measure?

Answer 24

• Calcultates the excess return on a portfolio vs the theoretical return of that portfolio according to CAPM:
• Alpha = Portfolio Return - Rcapm

Where Rcapm = Risk Free rate + β(Market rate of return - Risk Free Rate)

• This does NOT show manager skill, just the portfolio outperformance not explained by CAPM

Question 25

What is the Information Ratio and what does it measure?

Answer 25

• It compares the excess return achieved by a portfolio over a benchmark to the portfolio’s tracking error, which is calculated as the standard deviation of excess returns from the benchmark.

IR = the arithmetic mean of excess returns / benchmark σ

Question 26

What is R^2 and what does it measure?

Answer 26

• R-squared is used to denote the extent of diversification within a portfolio relative to a benchmark.
• The closer that the R-squared is to zero (ie, 0%), the greater the indication that its returns are not attributable to the performance of the benchmark index

Question 27

Holding Period Return of a Two-Security Portfolio

Answer 27

Overall Return = (% allocation of A * Return on A ) + (% allocation of B * Return on B )

Question 28

How many securities are needed to provide good diversification?

Answer 28

A portfolio that is equally weighted in 15 to 20 securities should diversify specific risk

Question 29

What is the synthetic risk and reward indicator (SRRI)? (used for UCITS funds)

Answer 29

• An overall measure of the risk (and reward) of a fund, ranging from 1 to 7, determined from volatility of past returns (as measured by the fund’s NAV) over a five-year period.
• The lower the score, the lower the risk (and, therefore, typically the reward) of the investment, while a higher score corresponds to a high-risk (and typically higher-reward) investment.

Question 30

What is the summary risk indicator (SRI)? (used for PRIIPS)

Answer 30

• A combination of two components: a market risk measure (MRM), which determines

1) the investment’s market risk on a scale of 1 (low risk) to 7 (high risk); and

2) a credit risk measure (CRM), which assesses credit risk within a range of 1 (low risk) to 6 (high risk)

Question 31

What is the Risk Premium on an investment?

Answer 31

The additional return it generates above the risk-free rate

Question 32

Which investment theory focuses on standard deviation?

EMH, MPT or CAPM

Answer 32

MPT

Given two investments with the same return, the one with the lower standard deviation would be regarded as the lower risk.

Question 33

Which investment theory focuses on diversification?

EMH, MPT or CAPM

Answer 33

MPT

The key way to reduce the risk of the portfolio is to diversify the portfolio

Question 34

When is the efficiency frontier curve it its steepest vs its flattest?

Answer 34

The lower the risk, the steeper the curve

As risk increases, the curve flattens

Efficiency Frontier

Question 35

Which investment theory focuses on beta?

EMH, MOT or CAPM

Answer 35

CAPM

It argues that the most important measure of risk is the sensitivity of the security to the market as a whole this sensitivity being measured by the ‘BETA’ of the security.